Analysing Revenues And Costs: A Starter

This article “Analysing Revenues And Costs: A Starter” by Cai Haoxiang was first published in The Business Times on 08 Sep 2014 and is reproduced in this blog in its entirety.

Look at segmental revenues to understand how a company’s sales mix is changing, says CAI HAOXIANG

LAST week, we discussed financial statements, when they are published by companies, and issues on interpreting them.

To recap, investors should evaluate financial performance using years, not quarters, to have a better sense of how the business will perform. Also, just because external auditors give a clean bill of health every year for a company’s statements does not mean the company is free from questionable practices or even fraud.

A company’s management is responsible for ensuring their assets are not misappropriated in any way. They – and not the auditors – are also responsible for preparing the financial statements.

What auditors do is to express an opinion on the statements, understand the company and its internal controls. And as we will see in the coming weeks, there are many ways for companies to legally fiddle with whatever appears on their financial statements, even within generally accepted accounting rules.

There are three main types of financial statements that appear in a quarterly earnings report: the income statement, the balance sheet and the cash flow statement.

This year, we will use, all the way through our discussion of the three financial statements, the example of mainboard-listed Eratat Lifestyle.

The choice of company is deliberate. Shares in Eratat, a Fujian-headquartered China footwear and apparel designer, manufacturer and distributor, have been suspended from trading since end-January.

Its former chief executive officer Lin Jiancheng is uncontactable. Cash is missing from its accounts. A bank statement showing hundreds of millions of yuan in cash has been found to be forged. The company’s operations have come to a standstill. Workers have not been paid for months.

In August, the High Court here put the company under judicial management. An external manager is now trying to preserve what it can of the business, without resorting to selling all assets in a bankruptcy scenario.

There was little warning last November, of what would unfold, when the company last released its financial statements for its third quarter. The same month, the company even won a corporate governance award. It was being tracked closely by the investment community and some research houses. But there were some clues hidden in the company’s financial statements that could have warned astute investors.

On blogs, and on investing forums, these red flags were consistently raised. Strong opinions were expressed for and against the company. Were these red flags there last November, in the third quarter statements for the three months ended Sept 30, 2013 – the last set of financial statements released to the public before Eratat was suspended?

That is the question we shall attempt to resolve over the next few weeks.

First, let us work our way through Eratat’s income statement.

Revenue refers to money brought in from ordinary activities of a business. It is known as the “top line”, and comes right at the beginning of any set of financial statements for good reason.

Sales Growth

Without selling goods to customers, it is meaningless to talk about profit. You might cut costs and be extremely efficient in production. But ultimately, if your sales are going down, the money you make is going to be limited.

That is why businessmen always talk about sales growth and new markets.

From Eratat’s Q3 2013 income statement, we see that the company did not have a good year.

While revenues only dipped 1.2 per cent for the nine-month period, compared to the nine-month period a year ago, gross profit was down 10.1 per cent. Similarly, revenues dipped 5 per cent for the three-month period compared to the same period a year ago, but gross profits were down 16.6 per cent.

This means things were worse in the third quarter than what came before it. Without further information, there are several ways to interpret this. Maybe people do not shop as much in the third quarter, but do so in the first, especially before Chinese New Year when they get their bonuses. Or maybe the company’s growth hit a temporary snag as it designs new products. Why is the decline in gross profit faster than the decline in revenues?

The reason is cost of sales, which have increased even as revenues decreased. Cost of sales refer to costs directly incurred in the production of goods. In Eratat’s case, it would be raw material costs used to make its shoes and fashion wear, as well as worker wages.

All else equal, when revenues fall, costs will fall in tandem. If the company sells fewer products at the same price, it requires less raw materials to make them, and presumably less overtime for its workers. If raw material prices remain the same, and no additional workers are hired, cost of sales should fall with less orders.

Here, there are more complicated factors at play to explain why costs rose despite a revenue dip.

Notes on pages 10 and 11 say there was indeed an increase in costs billed by suppliers due to “(industry)-wide increasing production costs”. Simply put, raw material prices are going up everywhere, and probably wage costs too.

The composition of revenue matters, and should be the first place investors look when figuring out why revenues rose or fell. From Eratat’s segmental results on page 10, we see that the company has two main segments, footwear and apparel.

Footwear, clearly, is on the way out. Eratat had changed its strategy a few years ago to position itself as a casualwear company. In the first nine months of 2013, sales of Eratat-brand footwear have almost halved to 66 million yuan (S$13.5 million).

Flat Overall Revenue

Eratat is selling more lower-margin third-party footwear, but those sales are not enough to stem the decline in footwear segment revenues.

Apparel now forms an increasing proportion of sales – more than three quarters of revenue, by the third quarter. Growth in apparel sales, as we can see in the third quarter and nine-month results, was flat.

So footwear sales are declining and apparel sales are flat. This explains why overall revenue fell.

Curiously, the notes say selling prices have increased. This is significant. Retailers try not to raise prices because that would dampen demand for their products. Can Eratat do so, and still sell enough products to keep its revenues up?

Eratat has raised prices for products carrying the Eratat brand – the core of the business. We learn from the notes that Eratat is selling higher-quality products to get a foothold in the higher-end casualwear market. It is trying to price according to quality.

But despite the price rise, revenue is flat or declining. This implies there are fewer pieces of clothing and pairs of shoes sold. How much fewer? To get an idea, just divide segmental sales revenue by the average selling prices mentioned in the notes. (Eratat does disclose quite a bit.)

For the third quarter, Eratat-brand footwear sales fell to 28.2 million yuan compared to 41 million yuan a year ago. Average selling prices increased from 175 yuan to 189 yuan. This means Eratat sold, on average, 149,000 pairs of shoes in the third quarter, down from 234,000 pairs the same period a year ago – a decline of 36 per cent.

Meanwhile, its apparel division, which accounted for the bulk of its revenues, reported sales of 241.7 million yuan in the third quarter compared to 240 million yuan a year ago, barely unchanged. But factor in selling prices that have gone up to 227 yuan from 185 yuan per piece and something more worrying shows up.

Third quarter sales of Eratat apparel are down to an average of 1.06 million pieces, down from 1.3 million pieces a year ago – a decline of 18 per cent.

Profit Margins

Other than analysing sales, one can also look at profit margins when evaluating a company. Profit margins measure how much money one is left with after deducting costs, as a proportion of revenue. To get gross profit margin, divide gross profit by revenue. They are a measure of how efficiently the company makes money.

In a high-margin business, you do not need to sell many products to turn a profit. Eratat gives a substantial amount of information on gross profit margins for its footwear and apparel segments. We see that margins have slipped quite a bit in the third quarter.

After looking at just Eratat’s revenues and gross profit numbers, we can come to some conclusions.

In the third quarter of 2013, retail sales in China grew at a rate of above 10 per cent a year on average, according to reports. China’s gross domestic product itself increased by 7.8 per cent in that quarter. The broader economy seems to be doing fine, but Eratat is not.

The investor needs to understand: Why are Eratat sales falling so much?

Eratat said that its market is “challenging and competitive”, but it was “cautiously optimistic” for full-year performance. In the fickle fashion world, retailers have to adapt fast to any industry trend change.

Investors, too, have to react fast to signs of decline. Eratat’s nine-month figures, and especially third-quarter numbers, are not encouraging. Profit margins are declining. Eratat’s branded apparel products – which the company had staked its future on – seem to be losing market share.